Are Bigger Bank Stocks Better?

Updated July 14, 2010 12:01 a.m. ET

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Collins Stewart

BANK STOCKS HAVE SLUMPED this quarter as investors have struggled with the Gulf oil spill, financial reform, and the shape of the economic recovery. While bank earnings continue to slowly recover from the financial downturn, the likelihood of more tepid growth and a slow economic recovery are likely to dampen any enthusiasm surrounding better-than-expected credit-quality measures over the near term.

Growth will likely remain nonexistent for the next several quarters, or perhaps longer, as waning confidence, higher capital levels, and regulatory reform each serves to dampen any meaningful growth prospects, at least over the near and intermediate term. Typically, it takes two to three years post an economic recession before measurable loan growth returns to the commercial banking sector; in fact, following the last significant recession in 1991, commercial loan growth lagged the trough in capital spending by about 11 quarters. Increasingly, the growth outlook, rather than credit quality, is quickly becoming the primary catalyst for the sector.

We fear that better-than-expected credit-quality results over the near term will be lost in the cloud of financial reform and mounting concerns of a double-dip recession. However, the key to excess returns is a balanced portfolio with both high-quality market-share winners as well as downtrodden names that have meaningful near-term catalysts—namely a definable turn in credit quality heading into the second half of 2010.

We are positively biased toward the large-cap banks with myriad revenue streams, operating scale and credit leverage.
Wells Fargo
(ticker: WFC) and
Bank of America
(BAC) remain two of our top picks, given the scope of the platforms and the revenue potential in the wake of better-than-expected economic data in the coming months. Although financial regulation will have a disproportionate impact on the financial supermarkets, our sense is that these companies are better positioned than the regionals given their relative size, scale, pricing power, and market-share positions.

Lost revenues can be at least partially offset through pricing, innovation, and market-share gains, whereas multistate spread-sensitive regional banks will have a tougher time offsetting higher operating costs. In terms of the regionals, our favorite best-in-class operators include
M&T Bank
(MTB) and
TCF Financial
(TCB)—companies which will continue to post positive market-share gains and rank among the first regionals to report improving fundamentals and loan growth.

The financial downturn has had a disproportionate impact throughout the U.S., both by industry and geography. Credit cycles, including recoveries, also tend to be uneven in nature--and we suspect that this recovery will be no different. In this report, we analyzed recent market-share data, credit-quality performance, and regional economic indicators to get a sense of which banks might be among the first to emerge from the credit cycle. Our analysis suggests regional banks with exposure to the Midwest and whose loan books are weighted toward traditional commercial and industrial loans are likeliest to show earliest loan growth; the Midwest has shown the most encouraging signs of an early economic rebound and credit-quality measures appear to be improving more rapidly relative to other parts of the country.

We favor names weighted toward commercial and industrial because manufacturing remains one of the few bright spots in the nascent economic recovery, given higher ISM manufacturing index readings, and a higher capacity-utilization rates, should benefit more traditional commercial and industrial growth in the coming quarters. Cincinnati-based
Fifth Third Bancorp
(FITB), with 28% commercial and industrial exposure, and Minneapolis-based
TCF Financial
(TCB) (13% commercial and industrial, but already posting growth), appear to be positioned well.

To be sure, market-share trends have been mixed over the last few years. While the large multinational banks have been holding their own (flight to quality/too big to fail), the regionals have ceded more share to smaller community banks, primarily due to both capital constraints and pronounced credit problems. That said, the large banks continue to hold a commanding market-leadership position, and we would expect that the large banks with national platforms, scale, and diversified product portfolios, such as Bank of America,
JPMorgan Chase
(JPM) and Wells Fargo to be net market-share gainers as the industry emerges from the credit cycle.

-- Todd Hagerman, Robert Greene

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